Max Loss is given as= (So- X) +Po
When share price falls put option gives us protection under the strike price. When share price rises put option lapses, so we should only forgo the put premium paid. Why we are doing (So-X) in case of loss?
Please explain.
The formula you have given, Max Loss = (So – X) + Po, represents the maximum loss that an investor can incur when buying a put option.
To understand why the formula includes the term (So – X), we need to understand the mechanics of buying a put option. When you buy a put option, you are essentially buying the right to sell a stock at a certain price (known as the strike price) on or before a certain date (known as the expiration date).
If the stock price falls below the strike price, the put option gives you protection by allowing you to sell the stock at the higher strike price, even if the market price is lower. In this case, your loss would be limited to the difference between the strike price and the market price, which is represented by (So – X) in the formula.
However, if the stock price rises above the strike price, the put option is no longer valuable, as you would be better off selling the stock at the higher market price. In this case, you would only lose the premium paid for the put option, which is represented by Po in the formula.
Therefore, the formula for maximum loss includes both the potential loss due to the difference between the strike price and the market price, as well as the cost of the put option premium.
Let’s say you bought a share @ 500 & if the share price goes beyond 500, you will gain but you are afraid of share price falling as you’ll have loss. So for that you bought a OTM put option at a strike price say 480 @ 45. So whenever the share price falls below 480 you will gain coz of put & whenever share price goes beyond 500 you will gain coz you have the share in your hand. But what about if it remains in b/w 480 – 500, here nobody are going to save you. This is deductible which you have to bear. So now if you look closely the max loss which you will bear will be this deductible amount + put premium which you had paid at the time of purchasing the put option.